Sorting out withholding: How to serve your workers best -- financially and legally

When it comes to tax withholding for you and your practice's employees, seemingly innocuous oversights can come back to get you.

The frequent shape-shifting of Internal Revenue Service rules and the steady stream of changes in people's lives and finances means oversights can arise easily. But they can result in more than a slap on the hand, initiating steep penalties and interest until the miscalculations are fixed.

Experts say poor communication might be the No. 1 culprit behind many of these mistakes. Late payments, bad information and shoddy help also can cause problems. To avoid the mess, they say, physicians -- new and veteran alike -- can benefit from understanding the common pitfalls in withholding.

Employer physicians are responsible for making sure that proper taxes are withheld from employee paychecks. The correct withholding amount is based largely on the employee's income and claimed exemptions. The bulk of withholding is for federal and state income tax and payroll taxes that cover Social Security, FICA and Medicare. The figures typically can be found using IRS and state tax tables.

It seems straightforward, but errors can occur in several ways.

First, there can be ambiguity about whether certain workers qualify as "employees." Perhaps a nurse practitioner works in certain scenarios but not all the time. Is that person an employee or independent contractor? The answer will determine whether taxes should be withheld.

"The key word is control. If the doctor controls the work product, controls the worker as to when they work, how they work and how the work is to be done, then most likely that person is an employee," said Keith Hall, a certified public accountant and national tax adviser for the National Assn. for the Self-Employed in Dallas.

Another potential pitfall is how employees fill out their W-4 forms, which spell out whether they file their taxes as married, single or head of household and determine the number of exemptions claimed. Once those forms are completed, it can be easy to forget to update them.

"People forget to change when they get married or divorced. You could be short or overpaid," said David R. Orenstein, a certified public accountant with Minneapolis-based Simma Flottemesch & Orenstein Ltd. He said the problem could apply to physicians' employees or to physicians who are employees themselves.

When those exemptions change, it can cloud a person's ability to gauge how much they might owe in taxes. If such a change is on the horizon, Jeffrey Soulard, a certified public accountant with Salem, Mass.-based Cabot Money Management, said calculators that will show the effect of different exemptions are available on the Internet and can at least provide some guidance.

Still, getting the right rate of withholding does not mean that physicians or their employees are out of the woods.

"The biggest pitfall that I run into is that there seems to be a misconception that if you withhold in accordance with federal and state guidelines, that in the end of the year you are going to come out even," said Philip Goldfarb, a certified public accountant with Weisberg, Mole, Krantz and Goldfarb, LLP, of Hicksville, NY. "There are a lot of other components to a physician's tax return that will impact what the ultimate tax is."

For every employee, the employer also owes a portion of the payroll taxes, and being late on those payments can result in penalties and interest. But even though the IRS and many state governments make it easy to automatically remit regular payments through electronic filing, some employer taxes might arise only occasionally, catching a practice by surprise.

Daniel Mefford, a certified public account and president of the Columbus, Ohio-based firm Practice Resource Management Group, said some states might require employers to pay taxes only occasionally into a workers' compensation fund or an unemployment fund. Managing due dates in this regard can be complicated and requires good organization, he said.

Soulard said some practices make the mistake of passing up the opportunity to lower the employer taxes that they owe by failing to offer employees programs that reduce their taxable income, such as health savings accounts and dependent care expense deductions. If employees lower their taxable income, the employer benefits because its payroll taxes are a match of what the employee pays, he said.

There are many more rules dictating how employers must handle withholding, including requirements that they file a quarterly payroll tax return, but many businesses, including physician practices, rely on an in-house professional or outside payroll services companies to do the nitty-gritty work.

Payroll services companies typically process the payroll electronically, taking out the specified withholding and ensuring that they go to the right place quickly.

But physicians can get in trouble if they use payroll services companies who can't be trusted to meet all the necessary deadlines and requirements of withholding. "Stick with a major brand in a major market," Orenstein said.

Even smaller practices might be able to afford payroll services, which could run $3 or $4 per paycheck or less. Orenstein said the low cost makes it a slam-dunk decision. "Whatever you think you're going to save [by doing it yourself], you'll screw it up once, it'll wipe out what you saved and it just ain't worth it," he said.

That thinking convinced Deborah Milburn, a practice administrator in Colorado Springs, Colo., that she would never go back to a practice where the payroll was done in-house. She used to work for a four-physician practice that had about 15 employees. Payroll was done every two weeks.

"You're talking about calculating pay, calculating withholding, writing checks," she said. Doctors also must submit the payroll tax, file quarterly payroll tax reports and produce W-2 forms at the end of the year.

"My time is more valuable. It had reached a point where I could contract that out and it was more efficient," she said. The practice switched to a payroll service, and now Milburn works for a larger practice that also uses an outside service.

Physicians who are self-employed and aren't on a payroll that is set up for withholding might have to do their own withholding of sorts by setting aside money to meet estimated quarterly tax payments. By their very nature, the estimated payments are just rough guesses. And to guess wrong could mean that at the end of the year you wind up owing -- and possibly owing penalties and interest as well -- or being due a refund.

There are two ways to make sure that estimated payments are close enough to avoid interest and penalties. One is to pay at least 90% of what you guess ultimately will be owed in the current tax year. The other is to pay at least 110% of last year's tax.

But both of these options have downsides. If you pay 110% of last year's tax to cover the current year, you run the risk of overpaying, and that means you've tied up money that could have been working for you in other ways. If you pay just 90% of the current year's tax, you'll owe on April 15, which happens to also be the due date for the first quarter payment of the following year, creating a double whammy.

Choosing which method to use depends on the preference of the individual and tax adviser. But even with a tax professional involved, both choices are subject to similar pitfalls that could mess up calculations.

For physicians, one of the problems is that practice income flows are often unpredictable. But Soulard said, "If you're keeping good records and you're doing business projections about what your income is going to look like next year ... it will go a long ways toward taking the uncertainty out."

Another problem is simply forgetting to include various income streams in the calculations or the information you pass on to your accountant. That could include a stock sale or some income from your spouse that slipped your mind.

"If you don't read all the stuff you get every quarter, then bingo, bongo, bango. It gets away from you," Orenstein said.

Frequently using different tax advisers could exacerbate this problem. If you use the same set of advisers, they might be able to spot things that otherwise could be overlooked. And of course, not being available for your adviser can make it more difficult, too.

Some physicians have a regular paycheck, for example from the C corporation they work for, as well as some estimated quarterly tax payments to cover alternative income streams, such as money from an outside consulting job.

It is possible to do this on your own. The IRS publishes reams of information about how the self-employed can withhold taxes for their employees and how they can estimate their own taxes to be paid in the required quarterly installments. Software programs are also available.

But juggling all of that responsibility without an accountant can be daunting. Orenstein said it is not for the faint of heart. "It's not a place for amateurs, unless you've got a lot of time and you want to make it your hobby," he said.

To Richard Erdey, MD, it made sense to hire a professional accountant, bookkeeper and practice management firm to handle tax withholdings from his employees' paychecks and to ensure that he is setting aside enough of his own income to make estimated payments for himself.

As a managing partner of a clinic-based ophthalmology practice and an ambulatory surgery center in Columbus, Ohio, he has come to believe over the years that running a successful business boils down to surrounding yourself with successful advisers who are experts in what is beyond your expertise.

"It's not what we're trained to do, to figure out the constantly changing guidelines," he said. Dr. Erdey's advice: "Get yourself a great accountant."